"I’ve read a bunch of books on personal finance," writes Charles, "but I’m left with a question I can’t answer, although I suspect it should be obvious. Probably, the engineer in me just wants a specific answer instead of the ‘feel-good’ answer. Which is better, borrowing $20,000 for a new car, or paying cash and investing the equivalent of the monthly payments? What I call the ‘feel-good’ answer is: ‘Of course, borrowing is bad, investing is good.’ But, how good? I need some tools to figure out when this makes sense and when it doesn’t. Or is it really so obvious that it ALWAYS makes sense?
"The situation I find myself in is that, for the first time in my life, I can afford to pay cash for a new car. But that cash represents 10% of my (non 401k) investment assets. Where earlier I only thought of the monthly payments, which didn’t bother me, I now find it EXTREMELY difficult to part with that much cold hard cash.
[You could always buy a nice used car for $6,000, Charles.]
"My wife came up with the idea of repaying ourselves the money in monthly installments, as if we were paying off a car loan. But the engineer in me says, ‘how much do we have to pay ourselves to make this a better deal than borrowing?’ Presumably, less than the loan payments would be, but how much less?"
Charles was beginning to lose me with this, and I will spare you the several paragraphs that followed with all kinds of engineering schematics, as it were, trying to get at the right answer.
But of course the right answer is very, very simple (never mind the fact that I can’t even light my grill, let alone engineer a chemical plant).
Not having to PAY 10% (or whatever) on a car loan is precisely the same as earning 10% (or whatever) risk-free, tax-free. (It’s tax-free because, except to a business, the interest on car loans isn’t deductible.) I know of no other investment that comes close to that, so buy the car for cash.
This has the added benefit of reminding you what you’re really paying for the car — not $400 a month, but TWENTY THOUSAND DOLLARS! Which might actually help you focus on your priorities. Maybe, seen that way, you really would prefer — voluntarily, not because I nagged you — a $6,000 used car, putting the $14,000 difference to work someplace else. That way, you save the better part of $14,000 and all the interest you would have paid on the car loan (and something on insurance, because you might decide to skip collision and comprehensive).
If the financing were 3% instead of 10%, then it would be different — except it wouldn’t, because they’d be offering you your choice of 3% financing or "$2,000 cash back," or whatever — so it’s not really 3%, it’s whatever car-loan lenders lend money at these days.
Sure, if you’re starting a business and need a nice car to impress clients and are short on capital, you’d finance the car — in fact, you’d lease it. The payments would be deductible, and while it’s hardly risk-free, your "return" on the $20,000 in start-up capital freed up by leasing could be 100% or 1000% or 10,000% if your business succeeds.
But to borrow $20,000 at 10% in order to keep it in a savings account at 5% (which is to say 3.5% after tax)? Or to put it into the market and maybe lose a chunk of it if the market turns down, or earn 10% pre-tax on it? I’d pay cash and consider "Not-Taking-Out-This-Loan" (symbol: NTOTL) one of your core holdings.
Incidentally, to figure out which car to buy, if it’s definitely going to be a new one, check out www.personalogic.com.